Erwin Schrödinger famously illustrated an aspect of quantum mechanics with a cat that is simultaneously both alive and dead.
Schrödinger’s cat sometimes comes to mind when we are asked about inadvertent investment companies – i.e., operating companies that fall into the definition of an investment company under the Investment Company Act of 1940. (For some background on the Investment Company Act of 1940, click here, here and here.) A practically minded business person might say: “OK, fine, the company is technically an (air quotes) investment company – why can’t the company just register as an investment company and still go about its regular business?”
The short answer is that only in the realm of theoretical physics is Schrödinger’s cat comfortably alive and dead at the same time. In the real world, a cat can only be one or the other. Similarly, we can confidently say that a company can’t comfortably function as both an operating business and as a registered investment company.1 As a practical matter the operating company would find it difficult (maybe even impossible), to function at all.
Put simply, “investment company” status is incompatible with an operating business because the Investment Company Act is designed to regulate funds holding portfolios of non-control, typically diversified securities. The Act is not simply a disclosure statute — it’s a substantive federal law of corporations that imposes extensive operating restrictions on investment companies. As a result, an operating company that is also an investment company will essentially find itself paralyzed. 2
Most notably, the Investment Company Act’s restrictions include:
Limit on affiliate transactions. Any transactions and dealings between an investment company and its affiliates are presumptively unlawful. The definition of “affiliate” under the Investment Company Act is very broad (see Section 17).
Ethics, compliance and recordkeeping burdens. The Investment Company Act sets forth detailed requirements for investment companies to adopt (i) a code of ethics, (ii) written policies and procedures to ensure compliance with federal securities laws and (iii) a recordkeeping policy. These policies must be reviewed at least annually, and in some cases quarterly, and the entire compliance system is subject to sporadic, in-depth, on-site audit and inspection by the SEC (see Sections 17, 31 and 38 and related Investment Company Act rules).
Limitations on capital structure. Investment companies must maintain (i) 300% asset coverage over debt (and 200% asset coverage over any preferred stock), (ii) only one class of debt and (iii) only one class of preferred stock (see Section 18).
Strict investment policies. Investment companies must adopt various policies governing investment objectives and concentrations, borrowing money and issuing “senior securities.” These companies must strictly adhere to these policies, which cannot be changed without a shareholder vote. Note that acquiring control of another company risks breaching the investment objectives and would likely require shareholder approval (see Sections 8 and 13).
Limits on directors, officers, underwriters and others. The directors, officers, underwriters and other specified related parties of an investment company are subject to a wide range of “bad boy” disqualifications, with a 10-year look back (see Section 9).
Requirements for independent directors. In general, at least 40% of the board of directors (and in many cases, at least 75%) must not have a material business relationship with the investment company, its entities or certain additional persons. These directors are also subject to heightened scrutiny, as the SEC has repeatedly emphasized that independent directors must act as “watchdogs” on behalf of investors (see Section 10).
Required investment adviser. The investment company would be required to appoint a registered investment adviser. Registered investment advisers are subject to the various rules and regulations of the Investment Advisers Act of 1940, which include adoption of a compliance program designed to ensure compliance with the Investment Advisers Act of 1940. Appointing a registered investment adviser requires shareholder approval and adoption of a written contract (also by shareholder approval), which cannot be assigned or changed without shareholder approval. The contract is subject to strict fee requirements and anti-assignment provisions (see Sections 10 and 15).3
Public filings; financial reporting. The investment company’s periodic filings, as well as its annual (audited) and quarterly (unaudited) financial statements are configured significantly differently from the forms used by traditional operating companies and may be subject to separate accounting requirements (see Section 30).
Changes in status. An investment company may not cease to be an investment company without shareholder approval (see Section 13).
Effect on MLP taxation. The Investment Company Act poses particular problems for publicly traded partnerships, also known as master limited partnerships, or MLPs. It is critical for MLPs to avoid investment company status at all costs. MLPs are not subject to tax at the entity level, and the MLP’s taxable income is allocated to its partners and taxed only at the partner level. Section 7704(a) of the Internal Revenue Code of 1986 (the Code) provides the general rule that a publicly traded partnership will be treated as a corporation for federal income tax purposes. Section 7704(c) of the Code provides an exception to the general rule for any publicly traded partnership if 90% or more of such publicly traded partnership's gross income for a taxable year consists of “qualifying income,” which is defined to include income from a number of activities, the most significant of which are related to certain natural resources. However, this exception from the publicly traded partnership rules generally does not apply to a publicly traded partnership that would be treated as a regulated investment company as defined in section 851(a) of Code, if such publicly traded partnership were a domestic corporation.4 Thus, a publicly traded partnership that is registered under the Investment Company Act is generally taxed as a corporation under the Code. In other words, a registered investment company generally cannot be an MLP.
The above is not a comprehensive list, but it is enough to highlight the main disadvantages of being inadvertently deemed an investment company. Thankfully, the Investment Company Act provides a wide array of exceptions and exemptions. Thoughtfully applied, these allow most operating companies to avoid becoming an investment company.
1 There have been isolated instances of operating companies seeking to register under the Investment Company Act, but we think they are the exceptions that prove the rule.
2 In commentary that might be applied to the more Delphic aspects of the Investment Company Act, Schrödinger pointed out that “[t]here is a difference between a shaky or out-of-focus photograph and a snapshot of clouds and fog banks.” Schrödinger, Erwin (November 1935). "Die gegenwärtige Situation in der Quantenmechanik.” Naturwissenschaften. See alsoLybecker, Martin and Chambers, Matthew (2003). “The Definition Of Investment Company: A Riddle Wrapped In A Mystery Within An Enigma.” 10 Investment Lawyer 1 (January 2003); and “Sequel to the Definition of Investment Company: A Riddle Wrapped In A Mystery Within An Enigma.” 14 Investment Lawyer 1 (July 2007).
3 Certain investment companies that elect to be regulated as business development companies are internally managed and do not have to hire a third-party investment manager.
4 To the extent provided by Treasury regulations, the exception from the publicly traded partnership rules will still apply to such a partnership if a principal activity of that partnership is the buying and selling of commodities (other than stock in trade or similar property described in section 1221(a)(1) of the Code), or options, futures, or forwards with respect to commodities.